Another Flurry of Trades

Remember a couple of days ago I said I thought the stock market was overpriced and due for a correction?  Well I certainly didn't expect it so suddenly.  Since my blog post on 2-August, the S&P has shaved off 6% of its value, dipping as low as 1163.25 (futures) on an intraday basis.  This intraday low represents a -13% peak-to-trough return in the past month. Meanwhile gold rallied hard (at first), making me very glad I hadn't taken my entire call position off.  I had another flurry of trades the last couple of days, most of them defensive.

S&P 500 (proxied by SPY) since 1-Jan-2011

Yesterday, my GLD calls were close to triple the price I paid a few days prior.  I was working a 400% profit order on 25% of them to secure a profit and let me continue to ride the train as long as I could.  As they hit their high, rumors emerged that big London-based hedge funds were getting margin calls on their gold positions.  Our company's market analyst mumbled the announcement about the rumors (a frequent problem lately), and NeighborTrader and I thought he said that the CME was raising its margin requirements on gold futures.  Either way, gold immediately went into a hard sell-off, and I was reminded of what happened to silver when the CME raised its margin requirement a few months ago.  Now gold today is a very different market than silver then, but that wouldn't stop a mini-panic from pushing gold down and keeping it there until my calls expired worthless.  To control the cost of this possible outcome, I sold enough calls to guarantee a profit, getting a trade price only 4c below the high.  Immediately afterward, the calls sold off and are now trading 33% lower.  Whew!  I still hold a little less than half my initial position at about double my purchase price, and if I let it expire worthless I will still make 6% profit - enough to cover commissions.

Gold (proxied by GLD) since 1-Jan-2011

The day after SPY opened below its 200-day moving average, causing CS|MACO to close its long SPY position, the AAII released its weekly investor sentiment survey.  Over 10% of investors stopped being bullish this week, which was enough to get a Buy signal out of the CS component.  Buy + Flat = Buy, so yesterday I bought SPY back at 124.30, which seemed great at the time (it was 3.50/share lower than where I sold it), but isn't looking so wonderful now that SPY is trading at 120.

I was working target exit orders on both of my SPY put positions, which I mentioned in the previous post; I never dreamed both of them would fill yesterday, but then yesterday was an unusual day.  Despite making a combined 56% on those puts, by the end of the day I was kicking myself for not holding the second batch until the market stabilized.  I left a significant amount of money on the table: the position I sold for $7/share is now worth $10.50/share, and the one I sold for $6/share is now worth $8.25/share.  Sigh.  NeighborTrader pointed out that I can't always sell the high, and I suppose he's right.

Yesterday crude oil dropped by $5.50/barrel, or -6% *on the day*.  If you need any confirmation that the global economy is slowing into a new recession, this is it.  Demand for crude waxes and wanes based on industrial activity, and the capital markets are exceptionally good at predicting and magnifying changes in demand.  When crude sells off hard over several days, it's a very bearish economic signal.  On 26-July, crude oil futures hit a high of 100.62/barrel.  Today's low in crude was 82.87: -18% in less than 2 weeks, a very bearish signal indeed.  I had an order working to buy USO at $35, which was filled yesterday during the craziness.  I'll buy more when I think we're near the nadir of the recession.

Oil (proxied by USO) since 1-Jan-2011

After the massive sell-off yesterday, I came in this morning expecting:

1. a better than expected monthly payrolls number
2. a big number-driven rally in the stock market
3. a post-number sell-off to yesterday's close price or lower by the end of the day.

In fact I was so sure about this that I bought Nasdaq futures at about 7:15, 15 minutes before the number.

What happened was:

1. a better than expected payrolls number (+117k/9.1% vs expected +85k/9.2%)
2. a big number-driven rally (S&P rallied about 19 points, Dow rallied about 280)
3. the craziest roller coaster of a day I've seen since the Flash Crash; S&P has had a 60-point range, Dow has had a range of about 460 points.  It closed 3 points below yesterday's close.

I sold back my futures immediately after the number for a $430/contract profit.  It's nice to be right every once in a while, and it's even nicer to be able to make a little money doing it.

The final trade of the day today was that Xilinx (XLNX) sold off enough to hit my target exit on the put position I've had there for a while.  At last glance, I sold the high price of the day in that option market.  That doesn't really make up for the SPY puts, but it's a start.

Victory From the Jaws of Defeat

It's been another exciting week in the markets.  Last Friday, the CiG trade sent up a buy signal on S&P Futures.  At the close, I dutifully bought at 1297.  Monday morning, all looked well as the market opened nearly unchanged and immediately rallied a couple points; that would prove to be the best price this position would ever see.  It fell the rest of the day, closing at 1285.25, a loss of $587.50/contract.  Tuesday looked great for a while, accelerating upward overnight to 1292 and reaching a high of 1295.5 - only a $75/contract loss - before giving it all back again in the last 2 hours of trading, ultimately closing at 1284.50, down another $50 from the previous day.  Wednesday was uneventful but painful, opening at 1282.25 and closing at 1277.5 - total per-contract loss: $975, ouch.  But then something interesting happened.  Another buy signal came along, this one on Russell 2000 Futures, giving me a decision to make.

In a previous trade a few weeks ago, I found myself in a similar situation: S&P had continued to move down for a couple days after initiating a position, costing me losses and threatening my stop-loss; then Russell signaled.  In that previous trade, I elected not to take the second entry signal, reasoning that in a real money account I probably wouldn't have or wouldn't care to risk additional margin on what I knew to be a highly correlated market.  That time, I watched as the Russell rocketed up the next day - I think I ended up scratching the S&P position, and missed a $1500 winner in the Russell.  After thinking about it some, I realized that a secondary entry like that is an even stronger signal.  CiG is a mean-reversion trade, entering a buy order when the market has sold down too much.  When it moves down even further, even more correctional pressure builds up, indicating a higher probability of the market returning to (or near) its previous range.

Or else it's the beginning of a downtrend, and your position is doomed - you never can tell which.

Since I try to learn from my trading mistakes (my many, many trading mistakes), this time I decided to take that secondary signal.  I bought Russell Futures at the Wednesday close for 787.  Thursday was the corrective rally I'd been looking for, with Russell reaching a high of 796.70, and S&P a high of 1294.  When it was clear I was seeing my rally, I changed my stop-losses into trailing stops so that I wouldn't have to babysit the position (I do have work to do, after all).  When the market started to sell off hard after 2:00pm, both of my trailing stops exited me from the trade at better prices than if I had waited for the close: 1289.50 for the S&P ($375/contract loss), and 794.10 for the Russell ($710/contract profit).

NeighborTrader pointed out that technically there was no exit signal in either product, and he's right.  But it was clear to me that the corrective rally had come and gone - staying in the trade any longer was asking for trouble, in my opinion.  Sure enough, Friday was another down day, with the S&P and Russell closing at 1269.75 and 779, respectively - representing a total stop-constrained loss of over $2000/contract.

I'll take a $365 profit while avoiding a $2000 loss any day, won't you?

*POP*!

It has been a busy month, and except for my mechanical trades (an update on those is coming soon), I haven't found the time to wander around looking at areas of the market that I don't usually trade.  About a week ago, though, I realized that I had heard a lot of buzz around the office about silver.  A month ago almost none of our traders were interested in trading silver futures, and now suddenly I was hearing about it from several different directions.  Curious, I brought up a chart.

(Silver ETF through May 2, 2011)

This, ladies and gents, is a bubble.  Having lived through the economic aftermath, we all have heard of the Tech Bubble of 2000 and the Housing Bubble of 2008.  Smaller financial instruments like silver don't get capitalized names, dates, and a lot of mainstream attention, because they don't push the economy around.  But here's a couple more from recent memory: the Oil bubble of 2007-2008, and the Agricultural bubble of 2007.  In the charts below, I have helpfully included the bubble-popping aftermath for 20/20 hindsight, which I held back in the Silver graph again (for the impatient, there is a full chart near the bottom of this post).

(Nasdaq ETF Apr1999-Apr2000)

(Oil ETF Mar2007-Jul2008)

(Commodity ETF Jan2007-Mar2008)

Sadly I can't find an ETF that captures the housing bubble well, but here is an excellent chart from another blog (thanks to James Parsons).  I haven't verified the source data, but it looks more or less correct.  The volume isn't pictured; in the context of home prices, that would be the real estate sales activity.  I could go do a bunch of research, but I won't.  We all remember the "flipping" craze of 2006-2007, right?

Housing prices 1970-2010, nominal and inflation-adjusted

In all of the charts above, notice the accelerating prices near the end of the bubble, and the corresponding accelerating daily volume.  This represents the "final blow-off phase", where everyone just has to be involved in this instrument.  Retail amateur investors do not belong in a frothy market like the ones pictured above, but the siren song of water-fountain stories about how Bob from Accounting doubled his money last month is a powerful draw.

In 2000, I had been reaping the rewards of the Tech Revolution, as I saw it, by working as an independent consultant on the side, more than doubling my salary by charging consultant rates and putting in 20-30 extra hours a week.  I suddenly realized that a lot of people had been making a lot of money in the stock market for a long time, and I was determined not to miss out on any additional free money.  I started reading the Motley Fool and buying more or less any stock that made a new high, with no regard for earnings (there weren't any) or prices.  I came late to the party, like most investors did, but I was convinced this New Economy (remember that?) was one that would love me and my technical mind, cradling me in its hammock of cash.  So I bought Yahoo at $120.  When it fell to $100, I listened to the Buy&Holders telling me what a great new bargain it was offering me, and I bought more.  When it fell to $60, I bought more.  When it fell to $40, I made my last purchase while gritting my teeth.  I don't remember where I sold it, but it certainly wasn't higher than $15.

I learned a lot in the next 8 years.  In 2008, when stock valuations were ridiculously high, the housing market was quietly imploding, and credit was rapidly shrinking, I heard a sudden increase in questions from people not involved in finance about how to get involved in finance.  I had doctors, dentists, and engineers wanting to argue with me about where oil was going in the next 5 years.  I had people telling me that $1.5million wasn't that much to spend on a 4-bedroom house with no land, and besides, you could just sell it for $1.8 in a couple of months! Suddenly everyone was a speculator, and everyone was loving the party.  Meanwhile I was reading economic analysis by folks like the Head Economist at Merrill Lynch, who was pointing out how silly it all was.  Every week he bemoaned the rapidly accelerating speculative frenzy, and forecasted a recession with increasing certainty and severity.  Finally in the summer 2008, I think in August, I decided it was time to take a position.  I bought puts on SPY, a lot of them.  I made about 800% on that trade; no, that is not a typo.  The money I made in that trade did not make up for the money I lost in my stock-index retirement accounts, but it certainly helped.

So a week ago, when I suddenly woke up and realized that I was seeing the top of a bubble in silver, I bought puts in silver.  I didn't buy many, because I'm unfamiliar with the market and I don't want to extend myself too far into a clearly volatile situation when I don't know what fundamental forces might be driving it.  Well, it turns out to be speculative craziness.  The CME decided to increase the margin requirements on its silver futures contract (SI), because it was seeing bigger daily ranges and was concerned that too many small speculators would be unable to make margin, leading to a meltdown (irony?).  Silver immediately turned about 120 degrees and headed straight for the floor.  I bought my puts the day after that announcement, so I missed the first big down day.  But here's the full-year chart of silver I held back at the top of this post:

SLV through present day

Is that not the most perfect bubble chart you've ever seen???

Two days later, I had more than doubled my money on the puts.  I sold a little less than half of them for more than I paid for the full position.  Now that remaining part of the position is worth more than twice my original investment.  In just a week, I'm up over 350% overall.  I like to use options for short-term directional plays like this, because I get leverage and limited risk.  I bought options worth about 4x more than I would normally initially invest in anything, and I spent about 5% of that on premium.  That 5% of the notional value is my maximum loss; leveraged out, I'm risking 20% of a unit of capital on this play.  It carries a high risk of loss, since the option really can (and often does) go to zero, but the leverage carries with it a high reward potential. 

Disclaimer:  it's tough to make money buying options.  It usually only works out well when there is a sudden violent movement - in the right direction - of my underlying stock/ETF/etc.  The problem, though, is that the probability of a sudden violent movement is captured in the term "expected volatility", and that's one component in the price of the option.  Just as you would pay more for car insurance if you had a history of vehicular homicide, you'll pay more for a put option on a stock that has a history of portfolio homicide.  So buying options usually loses money, and the art is to control that money loss and not let the option price go to zero.  But when they make money, oh boy.  I can turn a 30% drop in silver into a 350% profit.  That makes up for a lot of lost option bets.

This is usually where someone (you know who you are, Dad) tells me that I'm "profiting off the misery of others".  I see it a different way.  Do we all remember how it was the Evil Speculators that caused the 2008 crash?  Well, it's those same Evil Speculators that drove the silver price up above all reason.  Keep in mind, the catalyst for bursting this bubble was the CME increasing its margin requirements.  Do you really think that increased margin requirements are going to stop a hedger from buying silver futures because he needs a few truckloads of silver in a few months?  Of course not.  Do you think it would seriously impair the normal healthy speculation activities of the professional trading firms that provide markets to the hedgers, thus facilitating the modern financial system, as is their Patriotic Duty?  Certainly not - most trading firms have millions, if not tens of millions, in their margin accounts.  The only people severely affected by increased margin requirements are small-size speculators with underfunded accounts:  those 1-lot and 2-lot traders that are in there driving up the volume and generating water-cooler war stories.  These guys are cruising along with $10,000 to $50,000 in a futures trading account, and they're sitting at their desks trading silver all day long when they should be doing something productive.  This is why the Chinese are winning, people.

Think of it as weeding.  Sometimes you have to kill off some buckthorn so the oaks can thrive.  Think of me as a chipper/shredder.

Revamping CS|MACO

NeighborTrader and I have been talking a lot about back-testing lately.  Back-testing is when you take a bunch of historical price data, and push it through a trading strategy to generate buy/sell/close signals as if you were running the strategy at that time.  Then you see how the strategy did, and try to extrapolate how it might do in the future based on those results. Ever hear the phrase: "Past performance is no guarantee of future results"?  Well, the same applies to back-testing, but a little information is better than no information at all.

NeighborTrader back-tested the CiG trade before he ever talked to me about it last fall, and he's been combing through data ever since to find more trades he can run.  I've been meaning to do the same with CS|MACO for quite some time, and I finally did this weekend.  I learned some interesting things, and I found a few changes I want to make.

I grabbed daily historical prices for SPY from January 1993 through March 2011.  I also grabbed the AAII sentiment data for that same period of time.  I wrote myself a little Python script to collate the data together, and then plugged all of that into a spreadsheet that created signals just like my present-day trading spreadsheet.  To this, I added some calculations to figure out the results of the trades, and compare them to simply buying SPY and holding it. 

As designed and outlined in this post, CS|MACO underperformed SPY over the 18-year period from 1993-2011.  Then I abstracted away all of the parameters so I could change them easily, and started playing around.  Next I evaluated various time periods based on the sort of market they covered: I looked for bullish and bearish periods, triangular moves up and down, and sideways choppiness.  I compared CS|MACO against SPY in bottom-to-bottom and top-to-top time periods, as well as a simple 5-year rolling time period throughout the 90s.  Once I had a feel for how CS|MACO behaved in various market scenarios, I started changing the parameters, and learned some things.

The first thing I learned is that the 25/200 moving average crossover component of MACO is far too responsive, and tends to trade into choppy sideways markets, losing money on every reversal.  To catch the really big trends, much bigger moving average periods, and more similarly sized periods, are far better: 200/300 seemed to be a good mix.

The next thing I learned is that the arbitrary 10% collar I have on the CS component is about right, but only for the buy signal.  This outcome was fascinating, and I think it gives insight into individual investor psychology.  If I'm right, it means that the CS buy signal (which is based on below-average levels of bullishness in the survey) is a leading indicator while the CS sell signal (which is based on above-average levels of bullishness in the survey) is a lagging indicator.

Bear in mind, this all just my viewpoint: I think we as humans tend to invest our emotions as well as our money, and we are very slow to accept that we are in a losing position and get out of it.  On the other hand, we are much quicker to jump into a new position if we think there is opportunity there.  The vast majority of us do not short-sell anything (my father thinks it's un-American and somehow Satanic), and so statistically, investors tend to become bullish faster, and become bearish much slower.

To handle this lopsided behavior, I changed things so that I could control the bullish/bearish thresholds independently.  Then I tried turning one and then the other off by setting them so wide that the indicator could never reach them (+/- 100% certainly works).  I discovered that turning CS off entirely made things worse: MACO, by itself, is not a winning strategy.  Actually, let me be clear: it does have positive returns, but it does not beat SPY itself.  Turning on only the buy (bearish investors) signal had the most positive effect. 

So, how about the results?  In rolling 5-year periods, CS|MACO was profitable in just about all of them - can't say that for SPY, not by a long shot.  When it beat SPY, it beat it badly; when SPY beat it, it wasn't nearly as big a difference.  The best part is that CS|MACO tended to diverge up from SPY in down markets, and pace it fairly well in up markets.  It really only lost ground in prolonged sideways chop markets.  And by prolonged I mean like longer than a year of nothing but sideways chop - that's pretty rare.

A big danger of back-testing is sample bias, also known as curve-fitting or false optimization. This is where you optimize your strategy against all the data you have, and assume that tomorrow will just like your data sample.  In a perfect world, we would like to use a sample of, say, 1995-2000 to train our strategy, and then make sure it still works from 2000-2011 before committing real money to it.  This is called split-sample testing.  However, I feel that the behavior of the markets and the attitudes and psychology of the individual investors have changed somewhat over the last 18 years.  For me to find a strategy that works well in the 90s, and expect it to continue working in 2012 and beyond, is naive.  So I have to flirt with that sample bias problem, but I try to watch for it and be aware that it is always there without falling into it.

Below is a graph that compares SPY to CS|MACO for the whole 1993-2011 period.  SPY is the red line, and CS|MACO is the blue line.  Notice how when SPY suffers, CS|MACO profits.  This makes it a very viable strategy for running alongside a standard retirement account holding index funds.  And for me, that's just perfect.

(click for the original size)

CS|MACO... Finally!

Mea Culpa

First, I need to relate a painful but valuable lesson I learned last week.  In my previous post, I said that the CiG trade had fired a Buy signal on S&P Futures.  As a fade strategy, the CiG trade frequently signals trades that I view as bat-shit crazy.  It takes some teeth-gritting and reminding myself that this is fake money in order for me to be able to enter the trade sometimes.  Last Wednesday was one of those times.

I dutifully entered the trade, but I put a $500/contract stop-loss order in, instead of the $1000 that the script calls for.  I congratulated myself a couple of hours later when my stop-loss was hit, closing me out for a $500 loss, on saving the other $500 dollars.  Well... go look at a chart for S&P Futures.  My max unrealized loss that evening would have been about $700, and over the next two days we had a sizable rally.  By the time the exit signal arrived, the trade as designed would have been up over $2000/contract, a big return.  Instead, I was sitting on the sidelines with a $500 loss.  My "judgement", in this case, cost me a total of $2500/contract.  Ouch.

So why did I go against the trade as back-tested by NeighborTrader?  My rationale at the time was that this was a fundamental market move, and we were in uncharted territory that couldn't possibly be handled by back-testing.  OK, fair enough, and that's what judgement is for.  But I took the wrong action based on that judgement: instead of tightening my stop, which cut my max loss by 50% but increased my probability of experiencing that loss by far more than 100%, I should have opted not to place the trade at all.  If my comfort level with the risk is insufficient to execute the trade as designed, I should avoid the trade entirely - not cripple it and damn it to fail.

My conclusion was invalid, even if my assertion (these unprecedented times are likely to cause the trade not to work) was valid.  But what about my assertion?  If we want to look at unprecedented times, let's look at May 7, 2010, the day after the "Flash Crash" (I hate this term, by the way).  CiG would have similarly fired a Buy signal at the end of the day that day, and the exit signal would have come two trading days later, for a profit of over $2200/contract.  And here's the thing: NT back-tested this trade before May 7, 2010.  That's out-of-sample data, and thus can't be discarded as sample bias in his back-testing.

So my assertion -- unprecedented times invalidates the trade signal -- was invalid, and my conclusion on how to act on it -- tighten the stop -- was invalid as well.  Look, I'm not perfect, but if I had gotten either thing right, I'd feel a lot better about it.  Anyway, $2500 lesson learned: either follow the trade, or don't do the trade - don't adjust the trade on the fly based on my gut.

Oh, and you may recall me mentioning that "by rights, I should be short Ten Year Futures, too". That trade, if entered, would have made another $1250/contract over the course of three trading days.  Sigh.

CS|MACO

Last Wednesday night, not long after my stop-out, AAII's sentiment survey for March 17 was posted, and those inversely prophetic investors had some pretty negative things to say about the market.  Bullishness dropped all the way to 28.5%, just below the CS Buy signal level of 31.5.  With SPY trading between its 25SMA and its 200SMA, the MACO component was giving a hearty "meh" signal.  Buy + don't-care = Buy.  So I bought a unit of SPY the next morning... at 128.  SPY is still in MACO's "meh" territory, but up 1.66/share from my buy price; AAII publishes another weekly survey overnight tonight.  If my individual investor peers recognize the cessation of the downtrend last week and get more bullish ("bullisher"?), I might find myself selling SPY on the open tomorrow morning.  But they'll have to get a lot "bullisher" - 41.5% or more - for me to take my profits and go home.  We'll see.

General Thoughts

As regular readers of this blog know, I run multiple trades in my paperMoney account at ThinkOrSwim.  Besides the ones mentioned above, I also have a bullish NDX option vertical spread on to simulate a collar, a bearish SPX option vertical spread, an Iron Condor in RUT (Russell 2000) and naked-long SPY puts.  I'm also looking for a dip in gold to buy back some GLD calls, after having exited my March calls before expiration.  The problem that I am starting to run into is that I have too many trades on the stock market - and many of them are nearly perfectly inversely correlated.  The worst offenders are the bearish SPX and bullish NDX spreads.  CiG and CS|MACO only hold positions once in a while - but the option spreads are there all month long, every month.

This false diversification doesn't benefit me at all - if they were real trades I would be spinning my wheels spending commission on an expectation of about 0 profit.  In a paperMoney account, this isn't so bad, because I can use the excuse that I am looking for profitable trades: the unprofitable ones will never "go pro" into a real money account.  But this is kind of a hollow argument, because any of these trades can be profitable or unprofitable, depending on the market conditions.

This issue bears more consideration.

And a Micro Rant

"They", whoever they are, changed the Nasdaq-100 ETF's symbol from QQQQ to QQQ last night.  WTF???  Didn't they just change it from QQQ to QQQQ a few years ago?  Make up your minds!

CiG Finally Closed

As I mentioned in my previous post, the Collaboration-is-Good trade signalled a Buy on S&P Futures on Tuesday at the close.  This is a fade trade -- others might call it a mean-reverting trade, but it isn't really, since there is no "mean" we're reverting to.  By fade trade, I mean that it buys on strong dips of otherwise up-trending markets, and sells on strong rallies of otherwise down-trending markets.  So when S&P Futures shed 28 points on Tuesday after trending up quietly and strongly for months, CiG jumped on it. 

I bought S&P futures in my fake-money account at the close on Tuesday for 1314.50.  Wednesday close was 1305.25 (down another 9.50) and Thursday was 1302.25 (down another 3).  If I had simply held that position throughout that time, by Friday morning it would have been down $612.50 per contract, or about 11%.  But I didn't. 

Wednesday morning before the stock market opened, I saw the hard sell-off at 2am from the mess in Libya, and I decided that although futures had come mostly back that night, I should move my stop up to 1312.  Sure enough right after the open, the S&P sold off and hit my stop.  I got a little lucky on the execution, and sold it for 1312.25, saving $12.50/contract in losses.

By the close on Wednesday, the trade was still signalled, so I rebought at 1306, starting at -$112.50/contract.  Thursday was quieter, moving mostly sideways and a little down, and my trailing stop-loss of 10 points ($500/contract) was never hit.  It was still a down day, however, so the trade stayed signalled.

Friday morning, my tour de force of trading skill failed me.  I saw that the rally had finally started, and I wanted to set a closer stop before heading off to work.  Somehow I mis-entered the price, and instead of putting in a stop order to get me out on another big sell-off, I accidentally sold at the market, then 1311, for a reversal in fortune to +$137.50/contract.  Nice to have a profit, for sure, but I didn't want out at that point.

After arriving at the office, I kept an eye on the market and managed to buy back in at 1310 about an hour before the markets opened.  I then set a 5-point trailing stop, which is generally way too little room for this trade, but I was pretty skittish of the stock market by this time; and got to work on my day job.  Somewhere around 11am, after rallying all morning, there was a little market dip that closed me out at 1313, for another $150/contract.  I saw no reason to press my luck further, and closed the trade.

Total profit: $287.50/contract, or about 5% on margin capital.  If I had not been so skittish with my stop order on Friday, the close signal would have come in the afternoon at around 1318.75, profiting $575/contract, or about 10%.  On the other hand, my discretionary trading had a positive impact: if I had just bought on Wednesday afternoon and held on, the trade-prescribed 100-tick stop-loss would have just barely not kicked in at the low on Thursday, so my open-to-close profit would have been $225/contract.  So to recap, my discretionary trading was good, but I got a little more nervous on Friday than I should have.

Making the decision to violate the rules of a mechanical trade in real-time is always a tough judgement call.  Mechanical trades are useful for finding entry and exit points when an emotional human might not be able to pull the trigger on his own.  But blindly following them is not a long-term profitable decision -- despite my active trading behaviors, I believe in an efficient market most of the time.  In this context, that means that if there were a profitable mechanical trade out there, someone has already done it so much that it has been used up. 

By carefully considering whether now is the time to stray off the path laid out by the mechanical trade plan, and using the plan to question his decisions and lend some objectivity to their logic, an experienced trader can enhance his returns.  I'm not experienced enough to do that reliably, but in this case I had the help of NeighborTrader to reason out the pluses and minuses of each individual trading decision, and it worked out very well.

Collaboration, it seems, is indeed good.

Some Trades Are More Frightening Than Others

Not Frightening
Over the weekend, the Collar trade was assigned on its QQQQ calls, meaning that my QQQQ position was closed out at 58.  After the events over the weekend, and the markets today, that ended up being a great trade all by itself (QQQQ closed today at 57.03, down 1.70 on the day).

The QQQQ Collar trade has been one of the few that I have been running with real money, and it has been going for about 18 months now.  Over the last 18 months we have had, overall, a pretty significant up-trend to the market; and a limited-profit trade like a collar is going to underperform during strong up-trend periods.  Sure enough, I've made some pretty good money in the collar trade: just under 16% in 18 months.  But if I had just bought QQQQ and held it, I would have had a much better return: close to 39% over the same period.  Despite this drastic underperformance, the trade is a success - it is a super-long-term trade, and in losing years, its losses are much more limited than a simple buy-and-hold.  If it had not underperformed, that would be a signal that something wasn't being hedged correctly.

This trade is not without its problems, however.  First, there is a great deal of subjectivity about what strikes to use for the covered calls and the protective put - I tried to solve this problem by setting some range parameters.  Next, I have been running this trade in an online broker that is geared more toward stock traders than option traders.  As a result, its commissions for options are terrible: $10.75 for a one-way one-lot option trade, vs the $1.50 I negotiated with thinkorswim.  When I'm doing 14 option trades a year, plus the fairly frequent assignment fee of $25 followed immediately by the need to repurchase the QQQQ outright for $7 flat, it gets expensive fast.  Finally, I have noticed that the time value on the about-to-be-front-month options drains significantly over expiry weekend.  But since my online broker is very touchy about naked short options, I have to choose between an expensive fee-to-price ratio rolling trade, or letting the premium disappear over the weekend.

Since the collar essentially closed itself out over the weekend, I decided now would be a good time to transfer its required capital to thinkorswim and run it there.  I may retain the stock/call/put configuration, or I may run an equivalent position of a simple bullish vertical option spread.  If I do that, I lose the calendar component of the 6-month put vs the 6 1-month calls, but I'm not convinced that component is valuable anyway.  In any case, I have some research to do before the money transfer settles.

Frightening
Back to fake money, the CiG trade lit up like a Christmas tree today, thanks to those crazy Libyans.  S&P futures sold off 28 points or about 2%, which signalled a Buy at the close.  I have been bearish S&P for about 6 months (it has gained 300 points during that time) but this is a mechanical trade -- my viewpoint doesn't figure into it.  Have you ever tried to make yourself buy something when you don't believe in it and it has just sold off by 2%? It isn't easy.

The gold futures trade last month wasn't easy, either, but it turned out fine; by the law of single-datapoint-patterns, that means this one should be just fine too.  Nevertheless, NeighborTrader and I did have some vertiginous fun imagining that we were each managing million-dollar accounts and thus had to buy 100 futures knowing that each point would make or lose $5000.  That would make today a $140,000 losing day for that account, had it been long that amount.  I think I'm happier in fake money for now.

I also had a preliminary Sell signal setting up in Ten Year Note futures... we'll see what tomorrow brings on that one.

Somewhere in Between
Rounding out the flurry of activity today, the sudden market downturn made the volatility indexes pop about 4 points.  Everyone has heard of the VIX, which measures implied volatility in options on the S&P 500.  Since my iron condor trade is on Russell (RUT), I use the VIX's cousin: RVX.  Anyway, the 4 point pop in the RVX was just what I needed to get a better price on opening an iron condor position, since it is a negative-vega trade.  I put on the 760/770/900/910 April Iron Condor, for a credit of $3.25/share.  Pretty respectable, considering the low-IV environment we've had the last few weeks.  If the RVX is predictive, however, I'll be in for a roller coaster ride this month.

Trade Catchup

Iron Condor
This month I did something I swore I wouldn't do: I rode an iron condor position all the way to expiry.  Almost daily I took a good hard look at the position, and just didn't see a reason to close it.  It was somewhat underwater and getting worse as the gamma spiked up, but it wasn't through any of the strikes yet.  I reasoned that the increased loss incurred after the short strike went into the money didn't outweigh, on probability-weighted terms, the near-instant profit up to max I stood to make if it settled where it traded nearly all week last week.  If I had seen an inkling of a bullish follow-through in the Russell (my IC index), things would have been different.

I would have much preferred to get out of the IC early like I usually do, but it was a headache the whole way this month, trending up like crazy and refusing to give me any pullbacks to use for exiting opportunities.  Until the last week before expiry, that is.

With the market sell-off last week, we had a minor RVX spike, which I took advantage of by initiating the March condor position on Thursday.  I never did open a February position - January was keeping me busy, and the implied volatility was crappy.  March is already proving to be better than January, in that yesterday the call spreads inexplicably were priced at only a little higher than half what I sold them for.  I covered a couple of them, leaving most of the rest on.  March's strikes are 690/700/860/870, and they generated 2.35/contract in income when opened.

CiG
The big news is that the Collaboration is Good trade fired a buy signal on gold futures yesterday at the close.  Gold has had an ugly 3-week sell-off, and honestly I was starting to be concerned about my other gold positions in GLD, GDX, AEM, and GLD calls.  Gold futures have a $6750 margin requirement per contract, so I was glad this trade was in the paperMoney account, saving myself some sleep. Also, buying a gold futures contract after a 100-point sell-off would be a lot tougher in a real-money account, especially since with a contract size of 100oz, I'm looking at $100 per point per contract.  That's a lot of leverage: 100 oz of gold, with a street value of more than $130,000, for $6750.

Today the position started about 5pts in the red and continued to slide, bottoming out at about -7pts before gold suddenly started to go parabolic on an intraday basis before the FOMC announcement at 1:15 CST.  By the close, a profit-exit signal had fired, and I closed the position with a nice $1100 profit.  It rallied so hard during and after FOMC that it started to encourage me about my other gold positions.  A good hard rally after a CiG buy signal, historically, seems to result in some follow-through.

NeighborTrader, who was running this with real actual money, claimed he was going home to vomit into a trash can after closing his position this afternoon.   Sounds like it's time to increase the size...

Earnings Plays
Microsoft and Starbucks announce earnings this week: Microsoft tomorrow and Starbucks as I write this.  I have a sizable Microsoft position already, so I bought some puts on it as a hedge in case the stock slides after the announcement.  On the other hand, I have no position in Starbucks stock - but I have a natural short position in their products (nerdy trading humor, meaning I drink a lot of their coffee).  The market has been room-temperature on Starbucks for some time (insert more nerdy humor about room-temperature coffee here, if you like), and I recently saw some compelling arguments why a good report should send the stock higher overnight, so I bought some calls.  The conference call is still going on, but the numbers are out: Starbucks beat estimates and jumped its income by 44% this quarter, so of course the stock immediately slumped by 2.5% after losing 1% throughout the trading day.  Apparently they didn't raise their guidance enough to make everyone happy.

Oh well.

How should I root for Microsoft tomorrow?  Should I root for bad news, making a lot of money on the puts while watching my Microsoft position suffer?  Yeah, that's probably the best play, because I can use the profit from the puts to buy more stock at bargain prices.  Microsoft is a money-generating machine, and its stock price just makes no sense.

Collar
The most boring trade in my portfolio, the Nasdaq Collar, saw its covered call for January expire worthless last weekend, and I opened a new covered call position for February with a strike of 58.  Ho-hum.

Collaboration is Good

NeighborTrader has been making some comments lately about a trade he has been backtesting.  At first, he was trying to work out a way to make it an intraday trade so that he could run it at the office as part of his job.  A fairly new trader like him tends to prefer that route, because he has a lot more resources to throw at it sooner if it goes well than if he has to save his money to cover the margin.  Unfortunately for him, after playing with a lot of different variables he came to the conclusion that the trade worked best on daily charts, which means long-term holding times.  Since our firm has a day-trading culture and isn't really set up from a risk-management standpoint to hold trades for more than a few hours, that pretty much precludes him running it as part of his job.

Knowing that I've been running long-term trades in paperMoney, he chatted with me yesterday about his trade and the methodology he was using to backtest it.  I have to admit, I'm pretty impressed at how rigorous he's being with it considering: (a) he has no academic or professional experience with formal backtesting; and (b) it's something he's doing for himself on the weekends and committing very little capital to.  He even went so far as to buy historical data, something most of the guys at the office don't do for their big trades.  He also bought a book to learn proper backtesting methods to minimize the chance of sample bias and curve-fitting.

Since it's his trade, I don't think it's right for me to go into it in detail on a public blog.  He gave me all the information I need to run it myself, and suggested some products to run it in, and I plan to do so, although I can't think of a good name for it right now.  But I'll leave the parameters a little hazy to protect his intellectual property.  Suffice to say that it is pretty similar to CS|MACO in that it looks to enter positions contrary to market consensus, but only to do so when it isn't fighting a strong trend.  It seeks to buy dips and sell spikes, and it's purely technical, using indicators widely available on most charting packages.  It also trades very infrequently, so I might have to run it on more than one product just to avoid being bored.

He's been running it in S&P-500 Futures (it needs a lot of leverage to succeed, and he understands futures very well since that's his job) and a couple of other products.  He just exited a trade in it today for a nice fat profit.  Since I already have CS|MACO running on SPY (the S&P-500 ETF), and I have other trades running on other equity indexes (Iron Condors on Russell, Collars on Nasdaq-100), I think I'll run it against US Treasury 10-year Note Futures.  This trades at the CME since they merged with CBOT, and it's available in paperMoney. 

Speaking of CS|MACO, it's been quiet for a while now.  Individual investors have stayed bullish (they've been right for once), and SPY has stayed above its 25-day moving average.  Long+short = flat, so I've been watching this whole move from the sidelines.  The last couple of weeks haven't been good for any trade except iron condors, with the stock market going pretty much sideways.  Something has to give with CS|MACO soon, though, because the 25-day moving average and the closing price are converging.

A Little Free Advertising

I think some background might be useful before I jump into trade journal activities.  Most of the trades I will describe on this blog are being done in Think or Swim's paperMoney platform.  A few might be done with real money, and I hope that someday the realMoney/paperMoney ratio will increase.  But I have no intention to specify which ones are real and which ones are fake: my actual personal trading activities in the real market risking real capital are not something I want to put on the internet.  Likewise I don't plan to be very specific about position sizes or prices except where they are necessary to understand what I'm doing.  There also won't be profit/loss numbers.

There are two big reasons for not being very specific about these things.  The primary one is privacy: if I talk about my trading sizes, profit/loss, or which trades are real or fake, I give away personal financial information.  Additionally, though, I don't want anyone mimicking my trades.  If I wanted to be an investment advisor I would go off and get certified, and make a lot of money doing that.  Trades described in this blog are intended to be general ideas open for discussion, and they are certainly not recommendations or advice.  See that little disclaimer right under the title bar?  Yeah.  So if you're looking for stock tips, picks, predictions, or strategies, move along now and don't come back.  If you want to read about my own personal thrills and spills in the marketplace and interact with me about what I learn along the way, welcome.

In any case, assume that all positions are held in my paperMoney account (not real money).

So here's a little commentary about this thing called paperMoney, of which I am a huge fan.  Think or Swim has an interactive trading front-end written in Java.  This is great for me because I made the Windows-to-Linux switch about 18 months ago and I get kind of pissed off when I have to run a VM just to run a piece of software.  ToS's front-end is fully featured, providing charts, stock screening, real-time news feeds, trading grids, account/position management information, etc.  You hook it up to your trading account at thinkorswim.com and you're good to go: any trade you do goes against your buying power in the account and shows up both on your statements and in the front-end.

When you first connect, you choose between realMoney and paperMoney.  I have personally never used ToS's front-end for real-money trading - only paperMoney.  But from what I understand, paperMoney is exactly the same software except for two very important features: 1) trades in paperMoney don't actually make or lose you real money; and 2) market prices seen in the front-end under paperMoney are 20 minutes behind.  I'm sure that ToS does this because of republishing and licensing agreements with the exchanges providing the market data in the first place.  Another minor difference is that you start with $100k in your paperMoney account - I have no idea what you do if you go broke and hopefully I won't find out - so there is no depositing to do.  And execution is occasionally a little strange: ToS fills your limit order based on mid-prices instead of actual price action.  This is the best of a bunch of compromise approaches, in my opinion.  But you do sometimes get kind of a weird fill.  On May 6 (Flash Crash day), I had some limit orders working to exit some positions at ridiculous prices just so that I wouldn't forget about them, and they got filled at even better prices than I had specified.  What should have had a max-$2000 profit based on the option strategy ended up netting me $25k.  If only it was real...

The front-end is really well-tailored to options trading, which is why I selected it in the first place.  One of the screens shows position valuation graphs that can be played around with to examine the effects of underlying changes, delta changes, time, vega, etc etc.  Simulated trades can also be applied to positions from there so that an informed decision can be made before submitting the order.  I spend a lot of time on that screen before making adjustments.

I'm not sure how protective TD Ameritrade (owners of Think or Swim) are about screenshots and whatnot, so I won't post any here.  But check out thinkorswim.com and read all about it, if you haven't ever looked at their platform.  I'm really impressed with the software for having most of what I want in it, and I'm also really impressed at their willingness to let me paper-trade indefinitely without ever depositing any money.  That sort of accommodation shows confidence that their software is so good that I will still want to use it when/if I transition to a real-money option trader.  And that, my friends, is rare.

I sold some December 2010 calls on GLD today, taking my initial investment off the table.  My remaining position is all profit.  I did this today because of the fantastic run-up GLD has had over the past two months; some consolidation is due, and maybe a correction, so it seems like a good idea to reduce my risk and lock in a floor on my return.  Another reason is that the trader that sits next to me at work (we'll call him NeighborTrader, or NT) reported this morning that when he loaded up yahoo.com he noticed that the phrase "gold prices" was at the top of the Trending Now list.  That's a sign of a short-term top if I ever heard one.  It's a good time to hold a call option on my call position.

When NT's Iowa-residing grandfather asks about investing in gold, I'll sell the rest.